Recent press reports have glossed over a number of central facts when describing how federal tax laws were applied to companies that received government assistance during the financial crisis.
These stories present an incomplete picture.
Here is why:
A fundamental principle of federal income tax law is that corporations are taxed based on their profits. When a business is not profitable in a given year—when expenses exceed revenue—the business has a net operating loss (or NOL) and is not subject to tax. While our tax code requires businesses to calculate their income and to file tax returns annually, the tax code recognizes that profitability varies year by year. It therefore allows businesses to “carry forward” NOLs—to offset losses in one year against profits in future years. This is not a new or novel idea. It is a longstanding principle of our tax code, which is designed to measure taxable income more accurately over time.
The ability to carry forward NOLs, however, creates a potential issue.
It could encourage profitable businesses to acquire failing companies with significant tax losses in order to lower their own tax bills.
This type of trafficking in tax losses is not good for the economy or fair to other taxpayers.
Accordingly, in 1986, Congress enacted Section 382 of the Internal Revenue Code.
Section 382 prevents companies from evading taxes by buying companies with significant tax losses.
More specifically, it limits the ability of an acquiring company to use the NOLs of a target company to offset its own revenues when calculating tax liability.
Over the past 30 years, Section 382 has been an effective tool in preventing corporate raiders from evading taxes.
In the fall of 2008, the financial crisis threatened to put the global economy into a second Great Depression. When the Bush Administration and the Federal Reserve began making investments in private companies to prevent their disorderly failures and to protect the broader economy, Treasury officials recognized that these investments raised a novel tax question—did the government’s purchase or sale of private stock trigger Section 382 and limit the NOLs of those companies? In this unique context, Treasury concluded that applying Section 382 made no sense. Again, the provision originally was intended to prevent trafficking in tax losses. The government, of course, is not a taxpayer and has no interest in sheltering taxable income. It certainly did not invest in private firms to acquire NOLs. The government reluctantly made temporary investments to help stabilize the economy and to prevent a global financial collapse.
For these reasons, Treasury determined that guidance was necessary to clarify the scope and applicability of Section 382. Beginning under the Bush Administration in late 2008, Treasury issued a series of IRS Notices regarding Section 382. In general terms, the Notices provide that Section 382 does not apply to the government’s investments—both its purchase and, within strict limitations, its subsequent sale of shares in private companies.
This conclusion is fully consistent not only with the purpose of Section 382, but also with the government actions to respond to the financial crisis. The government had made large investments of taxpayer dollars to prevent corporate failures from causing a collapse of the financial system and resulting in even more severe harm to Americans. Allowing those companies to keep their NOLs made them stronger businesses, helped attract private capital, and further stabilized the overall financial system. It would have been counter-productive—and perhaps irresponsible—to undermine the stability of those same institutions, at the height of the financial crisis, by imposing a tax code provision that was never intended to apply in this context. Instead, the IRS Notices interpreted the law in the best interest of taxpayers.
For purposes of Section 382, an ownership change generally occurs when one or more 5% shareholders acquire more than 50 percent of the outstanding stock of a corporation during a three-year period.
Emily McMahon is the acting Assistant Secretary for Tax Policy.